Video communications provider Zoom (NYSE:ZM) was the hottest company on Wall Street until it wasn’t. From its Initial Public Offering (IPO) April 2019 to June 2019, Zoom stock soared from $36 to over $100. But ever since those highs, shares have steadily dropped to $70.
Why the sudden change of fate?
At first, investors were giddy about Zoom’s profitability. Unlike a handful of other growth companies that went public in 2019 such as Uber (NYSE:UBER), Lyft (NASDAQ:LYFT), and Slack (NYSE:WORK), Zoom is a big growth company that was already profitable at the time of its IPO. That’s rare, especially in this day and age. And investors celebrated that rarity by bidding up the stock to sky-high valuation levels.
Then reality set in. Just because Zoom is a profitable growth company, doesn’t mean the company is going to take over the world or that the stock deserves an intangible valuation. After all, Zoom provides video communications services for enterprises, and while that’s a good market, it’s also not that big, and it’s very competitive.
As reality set in, the hype surrounding Zoom faded, and the stock dropped. The good news for bulls is that it seems the worst of the sell-off is over. The bad news is that shares don’t have much upside potential from current levels, because the valuation remains full.
All in all, I think valuation friction will continue to hold back Zoom stock.
A Realistic Look at Zoom’s Growth Prospects
In the big picture, Zoom has good — but not great — long-term growth prospects.
The company provides video communications services to enterprises of all shapes and sizes. That’s a great market to be in. Communications services are becoming increasingly important to enterprise thanks to enhanced internet connectivity, and video is the future of enterprise conferencing. It’s very likely that, by the turn of the next decade, most sizable enterprises in the developed economic world will have a video conferencing and communications tool of some sort.
There are 1.3 million businesses with 10 or more employees in the U.S. There are 1.7 million such businesses in the EU, another roughly 300,000 in Canada, and another 50,000 in Australia. All told, there are probably near 3.5 million businesses with 10 or more employees in Zoom’s addressable markets.
Only 74,100 of them are signed up for Zoom’s services, which isn’t that many. And it’s not that many because the market for enterprise communications software is very, very crowded. You have Cisco (NASDAQ:CSCO), Microsoft (NASDAQ:MSFT), Alphabet (NASDAQ:GOOG), Adobe (NASDAQ:ADBE), Slack, and more. Sure, Zoom is considered a “leader” in the field, and growing its customer base at a robust 67% clip. But many of those competitors have much deeper pockets than Zoom, with much greater ability to integrate communication and video conferencing services with other products such as the Microsoft Office suite or Adobe Creative Cloud.
Consequently, the amount of customers Zoom acquires in the long run will ultimately be limited by the competitive marketplace. Yes, those customers will likely spend a lot with Zoom, and the company will run at a very attractive margins. Still, a lack of scale on the customer side should prevent Zoom stock from reclaiming a $100 price tag anytime soon.
Zoom Stock is still Fully Valued
Looking out long term, Zoom stock appears fully valued here at $75.
The math is pretty simple here. Zoom will end the year with over 80,000 customers with 10 or more employees. That’s up more than 60% growth year-over-year, and represents net annual adds of over 30,000 new customers. The pace at which Zoom is adding new customers has actually plateaued in 2019 (at around 8,000 new customers per quarter), whereas it has increased in prior years. This is a sign that competitive marketplace dynamics and scale are ultimately limiting how many new customers Zoom can add in a quarter.
Going forward, I think it is quite likely that Zoom sustains growth of 8,000 to 10,000 new customers per quarter. The average amount each of those customers spends on Zoom services has been rising throughout the past few years, and this should persist as Zoom employs a “land-and-expand” model and cross-sells various services to existing customers. At the same time, the amount of research, product, and marketing dollars that Zoom spends per customer is dropping thanks to economies of scale, and this trend will persist, too, creating ample room for positive operating leverage over the next several years.
Under all these optimistic assumptions, my modeling suggests that Zoom can go from about $600 million in revenue and 25 cents in earnings per share this year, to nearly $5 billion in revenue and $5 in earnings per share by 2030.
That’s still not enough growth to warrant much upside from current levels. Apply a medium-term application-software-sector-average 35-times forward earnings multiple to that $5 in 2030 profits and you get a 2029 stock price target of $175. Discount that back by 10% per year and you arrive at 2020 price target of $75.
That’s roughly where shares trade today, and we are in the first two months of the year.
The Bottom Line on Zoom Stock
Zoom is a good growth company, but investors in mid-2019 got overly excited about its rare combination of growth and profitability. They bid up the stock to unreasonably high levels and shares have been paying the price ever since. While the worst of this correction is over, the stock likely won’t rebound anytime soon either, and will instead remain range-bound for the foreseeable future.
As of this writing, Luke Lango did not hold a position in any of the aforementioned securities.
